Monday, October 28, 2013

Greasing a billion woks and filling them with pork is not easy, especially if you want some rice to go with the meal. An analysis published in Economic Times last month reveals that China's low barriers to agricultural imports have allowed the country's population to increase its level of food consumption--especially intake of fats and animal protein--to unusually high levels for a low-income country. The study's author argues that reversing the country's reliance on imports of soybeans and vegetable oils would hurt consumers more than it would help producers by raising prices and reducing food intake. His main point is that the country needs to view "food security" in a more "rational and scientific" manner.

Cheng Guoqiang, the author of "Causes and Consequences of Our Country's Increase in Agricultural Imports," is a leading authority on China's agricultural trade and a senior economist in the State Council's Development Research Center. His article debunks the fantasy that China can raise its standard of living and remain self-sufficient in agricultural products. He shows that China's availability of calories, fat, and protein have risen to first-world levels--improving the welfare of its citizens. But scarce land, water, and other resources dictate that China has had to increase its reliance on imports to do so.

Cheng says that it is now widely accepted that importing agricultural products is equivalent to importing land, water, and labor from foreign countries. He estimates that importing 10.7 percent of China's grain and soybean consumption is equivalent to importing 20 percent of the land needed to meet its food needs. The relatively large amount of land for imports reflects the low per-hectare yields of soybeans. China has pursued a strategy of importing soybeans to free up land for grain production, so-called "abandoning oils to maintain grain."

Cheng estimates that China's available supply of fats has risen by 321 percent since 1991--from 19 grams to 80 grams per day. He estimates that more than half of the fats come from imports--presumably soybeans, vegetable oils and other oilseeds. Cheng acknowledges that obesity and heart disease have risen in step with the consumption of fats. Cheng estimates that China is 83.9-percent self-sufficient in calories and 77.6-percent self-sufficient in protein. Cheng doesn't mention it, but the protein figures reflect a decrease in protein from wheat and rice offset by an import-dependent increase in animal-based protein.

China's focus on importing soybeans originated in the 1990s when the country's livestock sector development faced a severe lack of high-protein feeds. Authorities slashed tariffs, waived value added tax and eliminated quotas on imports of certain feed ingredients--chiefly fish meal, soy meal, distillers dried grains and other feeds that were high in protein and in short supply in China. (The VAT on soymeal imports was restored shortly thereafter because imports of soy meal were undercutting margins for domestic soybean crushers.) The tariff on soybean imports was cut to 3 percent and quotas were eliminated, setting off China's soybean import boom in the late 1990s. Soybean imports were minimal in the 1990s and are now approaching 60 million metric tons, providing oils for stir-frying (and greasy hot pot!), plus over 45 mmt of high protein feed ingredients.

Cheng's analysis makes clear that China imports mainly fats and protein. What he doesn't mention is that China's main agricultural exports are products largely comprised mostly of water: fruits, fish, and vegetables (mostly canned or processed using a lot of water). Thus, China's agricultural trade can be described as largely importing fats and protein in exchange for exports of water.

Cheng performs some simulations using a commonly-used economic modeling package called GTAP. He finds that banning soybean imports would raise domestic oilseed prices by 120 percent. That might be good for a few million soybean producers in China's northeast, but food prices would rise for consumers. He estimates that a 5-liter bottle of soybean oil would rise in price from 60 yuan to 110 yuan. Rice and pork prices would also go up. He doesn't explain how China could maintain domestic prices well above international prices if it wanted to do so without violating its WTO commitments and creating a huge smuggling problem (meat and rice smuggling is already rampant.)

Cheng Guoqiang's analysis clarifies China's agricultural trade and policies by reducing them to their fundamentals. While China was a nation of farmers until recently, its policy promoted cheap food for the urban population. Despite having a still-low per capita income, China's supplies of protein and fats are at first-world levels. Authorities selectively opened their borders to imports of fats and protein imports so they could concentrate on maintaining self-sufficiency of food grains--carbohydrates and basic energy.

The problem Cheng doesn't acknowledge is that authorities now have to raise grain prices above international levels (via trade barriers) to stimulate production and maintain their self-sufficiency (he does grapple with this issue in his other writings that recommend deficiency payment subsidies). Raising grain prices creates big distortions vis-a-vis oilseeds--minimal barriers to trade keep prices of fats and oilseeds at international levels while grain prices are elevated annually. The result is expensive grain and cheap oils. Excessive amounts of oils and protein are consumed (mainly from imports). Meanwhile oilseed production in China vanishes--an outcome which is blamed on bogeymen like multinational companies, USDA, and GMOs, but is really a creation of the Chinese government's own policies.

Wednesday, October 23, 2013

China's Ministry of Agriculture is laying down a propaganda barrage to convince the public that genetically modified foods are safe. Chinese news media have run a number of articles featuring various scientists explaining that GM foods do not pose a health threat. One article reported that a group of small pigs showed no ill effects after being fed GM rice for 90 days in an experiment at China Agriculture University. The Central China Agricultural University Professor overseeing the rice research says he has eaten GM rice for 14 years with no effects. A number of articles explain the science of genetic modification and assures consumers that China has laws and requirements for certificates and licenses that carefully control the import and production of genetically modified crops. In an interview with Peoples Daily Professor Luo Yunbo, Dean of the China Ag University's Food Science and Engineering College, repeated the official line that genetic modification is itself a neutral technology that must be used scientifically and strictly regulated.

This campaign coincides with a push to develop the Chinese seed industry. In an article describing Minister of Agriculture Han Changfu's instructions for implementing the State Council's priorities for economic work the only specific topic mentioned was an initiative to speed up seed industry research and innovation. (The dimsums blog reported on seed industry initiatives several months ago.)

The propaganda campaign seems aimed at laying the groundwork for commercial approval of GM crops for production in China as a food security strategy. Agricultural research on GM crops has been underway in Chinese institutes since the 1990s. Chinese farmers besieged by pests and weeds are eager to adopt GM crops. In May, Heilongjiang Provincial quarantine authorities said they seized and destroyed 115 kg of genetically modified corn seed sent from the United States.

In contrast, the Chinese public has grown increasingly skeptical of GM foods. With increasing numbers of Chinese consumers presuming that GM foods are a health threat until proven otherwise--a standard that is essentially impossible to meet--it seems likely that agriculture authorities will breed more cynicism with their campaign.

Wednesday, October 16, 2013

Chinese authorities have already implemented support price programs for wheat, rice, rapeseed, cotton and corn this year, but there has been no announcement of a soybean support price. According to China Grain Net, uncertainty about the support price policy has the Chinese soybean market in a deep freeze. Farmers are hesitant to sell at current market prices if the government later announces a higher support price.

The Chinese government has conducted a "temporary reserve" program to support soybean prices in northeastern provinces each year since 2008. The support price is usually announced in late October or early November, but there have been rumors that the temporary reserve for soybeans would be abandoned in favor of a target price program. In contrast, the support price for corn was announced three months ago but there have been no indications from the government whether the soybean temporary reserve will be implemented this year. According to the Ministry of Agriculture, 87.9 percent of soybeans had been harvested by October 10, but farmers still don't know what the policy will be selling their beans.

According to China Grain Net, farmers anticipate that the temporary reserve support price will be 4.8 yuan per kg, up from 4.6 yuan in 2012. The current market price is reported to be 4.3 to 4.6 yuan--below the expected support price level. The price for soybeans used for food processing--tofu, soy milk, etc--is about 0.4 yuan higher.

According to customs statistics, the average unit value of imported soybeans was US$ 608 in September 2013--equal to about 3.7 yuan per kg, well below the price of domestic Chinese soybeans.

While raising domestic soybean prices encourages farmers to plant them, it raises raw material costs for processors. Thus, if policymakers raise soybean prices too much they will drive processors out of business and have to buy all the soybeans themselves.

According to Chinese customs statistics, imports of soybeans during September 2013 totaled 4.7 mmt, the lowest volume in the last five months. China has imported 45.7 mmt of soybeans in the first nine months of 2013, up 3.3% from the same period in 2012. China is also importing more vegetable oils--5.5 mmt during the first nine months of 2013, up 8.7 percent from last year. Statistics for January-August showed palm oil imports were up 8.7% and rapeseed oil imports were up 67%, while soybean oil imports were down 26.5%.

Vegetable oil processed from Chinese soybeans has become less competitive due to high raw materials costs. Thus, the edible oil market has been mostly ceded to processors of imported oilseeds and imported oils. The China Grain Net article estimates that 60 percent of China's soybeans are used for food products like tofu and soy milk. It says most of Heilongjiang's soybeans are transported to food processing enterprises in southern regions of China.

Monday, October 14, 2013

Chinese authorities announced a wheat support price of RMB 118 per 50kg that will be in effect for the 2014 harvest in major wheat-producing provinces. This is an increase of RMB 6 from the 2013 minimum price. The minimum price doesn't go into effect until May 2014, but authorities announce the minimum price in the fall to encourage farmers to plant the winter wheat crop.

While this announcement continues the China National Development and Reform Commission's practice of raising the support price for wheat each year, the increase was not as large as many market participants expected. A Futures Daily commentary anticipates that the tight supply of wheat will cause the market price to exceed the minimum by the time the 2014 crop is harvested. Futures Daily thinks the government will not have to buy wheat and the price will be determined by market forces rather than policy.

A second commentary by a Chinese wheat merchant criticizes the wheat support price intervention policy, claiming that only middlemen benefit from the annual price increases. This commentary argues that subsidies for holding grain encourage depots to hold grain, artificially reducing the volume available in the market, pushing prices upward. The policy builds in expectations of ever-rising prices, reinforcing the tendency to hold grain as long as possible. The commentator insists that all the benefits of the price support policy accrue to intermediaries while farmers' costs rise faster than wheat prices and consumers pay higher food prices. The commentator says farmers don't hold their grain; they sell it as soon as it is harvested because they need to generate cash to plant summer crops, plus they have insufficient labor to dry and store the grain.

The articles fail to acknowledge that global wheat prices have been falling while China's have been rising. This probably is the main reason for the smaller-than-expected boost in the Chinese price support.

U.S. wheat prices fell during 2012-13. source: USwheat.org.

The second commentator worries that the support price policy is contributing to food price inflation in China. He says many people are unaware that Chinese prices for many commodities exceed international market prices. At an exchange rate of 6 RMB/$, next year's wheat support price would be equal to $10.70 per bushel. U.S. wheat futures prices for May 2014 delivery are in the range of $7.04 to $7.68 per bushel.

China's wheat supply has been tighter than production statistics suggest. The National Grain and Oils Information Center (NGOIC) reports that wheat output was 122 mmt this year, up 1.7 percent from 2012. However, heavy rains and storms at harvest time caused sprouting and lodging in some areas, reducing quality. Grain bureau statistics say that by September 30 a total of 54.5 mmt of wheat had been purchased by various enterprises in 11 major producing provinces. That total was 3.13 mmt less than last year, a decrease of about 5.7 percent. (Purchases of other summer-harvested crops--early rice and rapeseed--are both up slightly this year.)

The Futures Daily article points out that current ex-warehouse cash prices for wheat in China's production areas are above next year's support price, at RMB 2580-2620 per mt--about $11.70-$11.88 per bushel. The article reports that flour mills face cost pressure--strong wheat prices and weak flour prices--and calculates that mills face negative profit margins now that the peak demand season around the October 1 National Day holiday is finished.

With Chinese prices higher than international prices and its flour mills facing raw material cost pressure, there is strong impetus to import wheat. Despite the big wheat harvest, NGOIC estimates that China could import 7.5 mmt of wheat during the 2013/14 market year. NGOIC reports that China has already committed to purchase 3.7 mmt of U.S. wheat, 2.2 mmt from Australia, and 220,000 mt from France.

Thursday, October 10, 2013

Crop tours and news media indicate that China's 2013/14 corn output will increase this year. With the U.S. corn crop also likely to hit a record, and with demand relatively slow in China, the world could be flooded with corn after this year's harvest comes on the market. Paradoxically, Chinese price policies maintain strong demand for imported corn--and meat--despite the prospective glut of corn in China.

A corn tour covering China's northeastern provinces last month indicated that the volume and quality of this year's corn crop is a little better than last year. The crop tour found that growing conditions were good. This year's Chinese crop was only affected by flooding to a minor degree and was better than 2012 when typhoons, army worms, and heavy rain/snow affected the crop.

China's demand for corn is not that robust. A speaker at a corn industry conference said the corn-processing industry--which makes alcohol, starch, sweeteners and other products from corn--is going through a painful period of losses. Starch producers can only cover the cost of raw materials, the liquor industry is due for a big shakeout and monosodium glutamate producers mostly shut down in May. Many of these processors are operating at less than 50 percent of their capacity.

A speech at the same corn industry conference by Li Xirong, a livestock and feed industry official, surmised that excess capacity in China's poultry and pork sectors is dampening demand for feed. He estimated that tens of millions of rural migrants have gone back to their villages due to the economic slowdown--which has reduced consumption of meat. A second negative demand factor is this year's order to cut back on official banqueting--which also cut into demand for meat and alcohol--and by extension this weakens demand for corn. In particular, poultry and egg production--which account for half of industrial feed demand--is slow this year. The poultry sector has not completely recovered from the avian influenza and pharmaceutical abuse incidents that depressed the industry earlier this year.

Abundant domestic supplies and weak demand normally would push corn prices downward, but China's corn price support policy and restrictions on imports are preventing this from happening. While global prices for corn are plummeting, the Chinese price is supported by policy at a relatively high level. In July 2013, the Chinese government announced this year's support price for corn in the northeastern provinces would be increased from last year, to a minimum of RMB 2220-2260/metric ton in various provinces--about $9.40-$9.60/bushel. While Chinese officials have been trying to engineer an increase in their corn prices, U.S. corn prices have fallen from a drought-induced high of $8/bushel in 2012 to near $4.50/bushel recently.

Liu Xiaoran said the after-tax cost of imported corn in China is now RMB 2039/mt, about 15 percent less than the current cash price of RMB 2400/mt in the Chinese market. With domestic prices elevated above international prices, Chinese buyers are paradoxically clamoring for imported corn despite the prospect of a big glut of corn in the domestic market. China's 2012 imports--when U.S. corn was expensive--totaled 5.2 mmt. This year, with U.S. corn prices plunging and Chinese prices stuck at a high level, there is even more inclination for Chinese buyers to import corn.

However, China's tariff rate quota effectively caps corn imports at 7.2 mmt per year. Half of that quota is awarded to state-designated companies--mainly state-owned COFCO--while the other half is split among hundreds of private sector applicants.

The high cost of corn has encouraged Chinese users to seek out substitutes. A speech by a COFCO analyst at the September corn industry meeting noted that the rising cost of corn from 2007 to 2012 had stimulated increased use of wheat for animal feed (an unintended effect of China's policies to boost wheat output as a "food security" measure). Chinese users began importing distillers dried grains from the United States in 2009, and he estimated that DDGS imports could rise to 3 mmt this year. He estimated that China's imports of sorghum--a more expensive substitute for corn--could reach 1.5 mmt during this market year. China has no quota limits on imports of either DDGS or sorghum. The COFCO speaker noted that China's corn demand had slacked off since the second half of 2012.

The drop in U.S. corn prices could have knock-on effects on livestock and meat trade. U.S. livestock producers paying corn prices half those of their Chinese counterparts will boost supplies and drop prices. A corresponding gap between Chinese and U.S. meat prices could stimulate more Chinese imports of U.S. pork and chicken. Thus, China could end up importing more corn in the form of meat and poultry by next year.

With corn having shifted from shortage to surplus, the risk is that an usual year of bountiful corn supplies will lead to wasteful policies to use up surplus corn. Li Xirong's speech cited above recalled China's huge corn surpluses in the 1980s when much corn was wasted and exported with subsidies. The speech on industrial use of corn cited above recalled that Chna's corn-processing sector was set up (with subsidies) during a period of corn surpluses in the early 2000s to help farmers dispose of corn they couldn't sell. He praises the industry for increasing demand for corn. However, since then the livestock industry's demand for corn has exploded and competes with industrial processors, sending corn prices upward--until this year. The speaker calls for renewed subsidies and policies favoring export of corn-based products to help the processing industry through its rough patch. This year's prospective glut could stimulate similar policies.

Monday, October 7, 2013

A report issued by a health issues governance research center at Fudan University highlighted some administrative problems that hinder food safety oversight and regulation.

Based on the brief summary released to news media--the full report doesn't seem to be available online--the report noted the complexity of food safety supervision in a supply chain with many enterprises and multiple links. The report said that China has emphasized a complete "farm to table" approach to food safety governance since 2009, but there has been little research looking at the system as a whole and the logical connections within it. Recent incidents--melamine, "sudan red" dye, dyed steamed buns, and clenbuterol "sounded the alarm bell." Setting up effective systems to achieve control is essential to addressing chronic food safety problems, the report said.

The report emphasized regulatory and enforcement problems that prevent food safety improvements. First, China has 840 food safety-related laws, regulations and policy documents. There are different national, provincial and industry standards and China's domestic standards are not harmonized with those of international counterparts.

A second important problem cited by the report is the fragmented and blurred enforcement responsibilities of different government bodies. The fragmentation is in both vertical and horizontal dimensions. There are central, provincial, municipal and local regulatory systems for food safety regulation. Local authorities are often underfunded or their interests are aligned with those of the industries they are regulating. The report cites "improper administrative behavior"--perhaps a euphemism for corruption--as another problem.

In the vertical dimension there are different departments with responsibilities for different parts of the supply chain: agriculture departments for farming, commerce and industry for trade and transportation, technical supervision bureaus for processing, health bureaus for restaurants, etc. A quarantine and inspection bureau oversees food safety for exports and imports.

Consequently, the various regulatory authorities have blurred responsibilities and there is little oversight of the entire system. Food safety problems often arise when perpetrators find loopholes and spaces in the industry that no one is watching. Enforcement varies widely from place to place. Safety hazards abound in rural areas and back alleys of cities while import-export authorities adopt strict zero-tolerance standards inspired by Japanese and European counterparts. The zero tolerance standards may be strictly enforced one month and ignored in another month.

The Fudan University report is a positive step forward in viewing the underlying governance and incentive problems behind China's food safety problems. True to Confucian form, it emphasizes "coordination"--implying gigantic administrative structures with stronger sanctions and enforcement powers that give bureaucrats even greater concentration of authority. China's food safety law was intended to address these problems, but regulatory inertia is much stronger than most people realize. Redrawing an organizational chart doesn't change the people and their allegiances that undermined enforcement mechanisms in the first place.

The Fudan Center for Collaborative Monitoring of Health-Related Social Problems that issued the report also appears to be confucian in that participants apparently were scholars--mainly from medical universities--and officials. According to a description of the center's founding in March 2013, the center was sponsored by the Ministry of Education and various officials with health-related responsibilities to discuss and find innovative solutions to food safety and other public health problems, specifically citing SARS, avian influenza, melamine, and "haze." The center doesn't appear to have significant representation of agricultural, commerce, foreign trade spheres. Confucian officials have long viewed farmers as ignorant and merchants as crooks, but an effective system will have to ensure that farmers and merchants have incentives to provide safe food--even when no official is watching.

The Fudan health governance center also subtly reveals that the idea of a government "of the people, by the people, and for the people" is still a distinctly foreign concept in the Orwellian Peoples Republic of China. Food safety regulation is motivated by a desire to strengthen the State. In explaining why it is important to address food safety problems, the description of the center's founding emphasizes the threat of social instability and damage to the government's credibility, "even shaking the ruling position." The chief concern of the report is that food safety incidents harm the international reputation of China's food industry. The interests of consumers are mentioned as a concern only because unhappy people might rise up against authorities.

Thursday, October 3, 2013

Shuanghui International Holdings recently completed its acquisition of Smithfield Foods Inc., the largest Chinese acquisition of a U.S. company to date. This acquisition of overseas pork production capacity is ironic in light of a May 2013 Chinese Ministry of Commerce document that reported a massive effort to shut down pork processing facilities in a domestic industry that utilizes only 42 percent of its production capacity.

China's pork industry has added hundreds of large mechanized slaughter facilities with global-standard food safety and sanitation controls, but thousands of older rudimentary slaughter facilities still operate alongside them. According to the report, China's hog slaughter industry utilizes just 42 percent of its capacity. Its annual processing capacity was 850 million hogs but actual volume was reported to be 355 million head. The audit program reflects a strategy of shutting down small facilities that lack required equipment and facilities to remove excess capacity and consolidate the industry by brute force.

China Hog Slaughter Industry, 2012

Item

Unit

Value, 2012

Percent change

Number of slaughter enterprises

Number

14,720

-26.2

"Designated" slaughter enterprises

Number

5,919

-22.5

Small scale slaughter points

Number

10,135

-27.7

Gross income

Billion yuan

271

2.80%

Average hog purchase price

Yuan/kg

15.73

-8.1

Ex-factory carcass price

Yuan/kg

20.68

-7.2

Value of assets

Billion yuan

106.4

11.9

--above scale enterprises

Billion yuan

95.3

13.7

Source:
China Ministry of Commerce.

By comparison, U.S. pork industry statistics listed 71 U.S. slaughter plants with capacity to process 445 million hogs in 2009. Another table listed less than 30 U.S. plant closings between 1993 and 2009. Chinese authorities closed over 5,100 slaughter facilities in one year.

The Commerce Ministry report cited excess capacity and a low degree of concentration as major problems facing the Chinese pork industry. The report pointed to the high degree of concentration in pork markets in the United States, Holland and Denmark as presumably superior to China's small, scattered collection of slaughter facilities. The report said China's biggest companies--Shuanghui, Yurun, and Jinluo--have expanded rapidly and invested in slaughter, processing, cold chain, and testing facilities, but the degree of concentration is still low.

The volume of hogs processed by Chinese facilities reportedly rose 4.1 percent during 2012, despite having shut down 26 percent of slaughter facilities. This suggests massive consolidation, but the share of hogs processed by the top 50 enterprises rose only 1 percentage point, reaching 14.8 percent in 2012. "Above-scale" enterprises (20,000 head per year) accounted for 78 percent of volume, up 2.4 percentage points. The value of industry assets increased 11.9 percent despite the loss of a fourth of the facilities.

The report also worried that the Chinese pork sector remains a low-margin sector with minimal value added. The slaughter sector largely kills and cuts up pigs on commission for wholesalers. The primary product is a "hot" carcass that is carved up later the same day by a retail butcher within miles of the processing facility. Packaged and chilled meat cuts constitute only 10 percent of the pork market, and processed meat products account for only 15 percent. There is little product differentiation or branding, says the report, and profit margins are 1.8 percent of gross income.

In a low-margin sector there is little ability or inclination to invest in equipment and facilities to address the industry's chronic problems with food safety and environmental pollution. The report says some operators are conscious of food safety, but a series of food safety incidents results because many operators flout food safety regulations and the testing system is "imperfect." The report notes that hog slaughter facilities generate large volumes of waste water. But the treatment costs to mitigate their "heavy pollution" are high, too high for many small facilities to bear. With heightened concerns about pollution, more municipal authorities are expelling hog slaughter enterprises--either pushing them underground or into the hinterland far from cities.

The expansion of high-end facilities on top of a vast network of thousands of low-margin butchers has created a confused multi-tiered Chinese pork industry. The audit/remediation campaign represents an attempt to consolidate the industry by brute force by shutting down the low-end processors/butchers. In theory, eliminating these competitors should allow the remaining big enterprises to raise prices and expand volume to cover the higher costs of modern facilities.

The first point of confusion is over how big the Chinese pork industry is. There are multiple statistics on China's hog slaughter total ranging from 223 million to 698 million head:

698 million hogs--China's National Bureau of Statistics (NBS) official hog slaughter total for 2012.

355 million hogs--The Ministry of Commerce report slaughter number for 2012--about 51 percent of the NBS number.

270 million hogs slaughtered by "above scale" enterprises (more than 20,000 head per year) in the Commerce report--39 percent of the NBS number.

Adding to the confusion, the Ministry of Commerce reported monthly hog slaughter statistics on an official website for monitoring the pork industry. Adding up the monthly numbers yields an even smaller number: 223 million hogs--32 percent of the NBS number.

How can we reconcile these slaughter statistics? The difference between NBS and Commerce statistics reflects to some degree the persistence of onfarm and small-scale butchering in the countryside that is not captured by the Ministry of Commerce. As many as two-thirds of China's pigs may be slaughtered on farms or by small butchers and don't show up in the Ministry of Commerce's statistics. However, the statistics are probably not accurate. It is unclear how NBS manages to accurately track and measure small-scale farms and butcher points. Many farms and butchers have an incentive to evade regulatory and statistical authorities. However, others have incentive to exaggerate numbers to collect subsidies for sows, hog insurance and vaccines. It is likely that NBS slaughter statistics are overstated and Commerce Ministry statistics are understated.

The statistical problems are a reminder that China's pork sector is a confusing multi-tiered market that includes:

farmers killing pigs for their own consumption,

small farms and butchers that supply small retail vendors and restaurants,

modern supply chains for supermarkets and high-end food service establishments.

These segments or tiers operate in parallel with blurred and ever-shifting boundaries. Most supermarkets and high-end restaurants are supplied by the modern supply chains but some procure pork from small butchers and underground swill-feeding hog farms. "Wet market" vendors and small restaurants mainly procure pork from small butchers and associated brokers and dealers, but an increasing share of these outlets are procuring from "modern" supply chains. Perhaps 25-30 percent of rural residents raise their own pigs (down from 60 percent in the 1996 agricultural census), so few "farmers" kill their own pigs--most buy their pork from markets or eat in restaurants.

To make things more complicated, retail outlets may shift their source for pork from month to month depending on market conditions and whether government officials are in crackdown mode. Supermarkets and butcher booths displaying large photos and descriptions of modern-looking hog farms may actually get their pork from small butchers. In some cases, the retailers may intentionally deceive their customers, and in others the retailers themselves may be duped by their suppliers about the source of their pork.

There is really no way of knowing the true number of hogs slaughtered and sold in China, but the various hog slaughter numbers indicate that China's "modern" commercial pork market is much smaller than official slaughter numbers indicate.

The Commerce Ministry's report indicates an industry in a state of flux. The Ministry is one of nine departments--including police, agriculture, sanitation, environmental and other authorities--engaged in more aggressive monitoring, education and enforcement to "root out criminal networks" to stamp out "black dens," "black workshops," and "black markets." The report doesn't acknowledge it, but these efforts often lapse when one or more of the nine stove-piped departments lose interest or officials from higher levels go home. Sometimes these efforts create other problems--a campaign to shut down a network of diseased meat dealers in Shanghai and its hinterland last year resulted in farmers dumping their dead pigs into rivers (instead of selling them to butchers as was customary).

The report calls for continued efforts to consolidate the industry using sticks and carrots. There will be continued audits and shut-downs of substandard enterprises, as well as "encouragement" and subsidies to companies to invest in integrated supply chains, retail networks, upgraded facilities, testing equipment, information technology to facilitate traceability, and water treatment equipment. Medium-range plans call for increasing the share of products sold as packaged or processed products. The processing industry is to restructure with big companies investing in cold chain and interregional sales networks. There is also an initiative to develop the meat industry in border regions and areas populated by ethnic minorities.

The bottom line is that authorities have failed to provide a consistent, clear regulatory environment to govern the pork industry. Thus, the industry or "the market" has not been able to sort out problems on its own. Citing "market failure" (which is really regulatory failure), other arms of the government have jumped in to restructure the domestic industry by brute force--shutting down substandard butchers and giving subsidies to others to buy equipment, build facilities...and buy companies overseas.

Returning to Shuanghui, it remains a mystery how a company operating in a low-margin industry could scrape together $4.7 billion to pay a substantial premium to buy the shares of Smithfield Foods, a much larger and more valuable company (and take on $billions of Smithfield's debt). The massive investment in an overseas company is ironic given that the Chinese pork industry is utilizing less than half its existing processing capacity and is chronically short of capital investment.

A possible explanation is that Shuanghui needs a reliable supply of quality pigs that is walled off from the chaotic Chinese hog farming-slaughter industry and the only way to get a reliable supply is to find it overseas. It is probably no coincidence that Smithfield is known as a proponent of the vertically-integrated management model that Chinese industry mavens see as the future of China's pork industry.

The Commerce Ministry's report gives the impression of a long, slow slog to upgrade value-added and net margins in the Chinese pork market. There will be a market for high-end branded (Smithfield/Shuanghui) pork products in China, but it will be a tiny sliver of the market for the foreseeable future. The five-year plan set a goal of increasing the market for processed meat products in cities by 25 percent between 2010 and 2015 with a target market share of 17 percent in 2015. And that's the "modern" segment of the market which may be about two-thirds smaller than indicated by the NBS official slaughter statistics reported in the news media.